As a virtual CFO for various enterprises, over a period of time, I observed that most of the start-ups and Small & Medium sized Enterprises (SMEs) lack a strong internal financial controls. Earlier, in the initial days, the business owners does not consider and understand the importance of internal financial controls and the realization came to them after something unfortunate happen with the company. Designing and implementing internal controls is a preventive measure and strong internal controls policies prevent a fraud, misappropriation of fund and ensure accuracy of the financial statements.
Developing and implementing a strong internal financial controls method and procedures could not be same for all the enterprises, it vary industry to industry and company to company. We are here to provide a general systematic step-by-step guide to develop a strong internal controls.
Step 1. Understand the Internal Controls
Internal financial controls are the policies and procedures that a company puts in place –
a. to protect its financial assets,
b. prevent fraud,
c. to ensure accurate financial reporting
d. to comply with laws and regulations,
e. to improve efficiency, and
f. to make better decisions
They are essential for any business, but they are especially important for start-ups, small businesses and businesses that operate remotely.
Let's look at an example of why understanding and implementing internal financial controls are crucial for an Indian start-up named "Techmantra," which specializes in providing software development services.
Meet Rahul, the founder and CEO of Techmantra. In the initial stages of the business, Techmantra experienced rapid growth, with multiple projects and an expanding client base. As the workload increased, Rahul started to notice some inconsistencies in the financial records, which raised concerns about the company's financial management.
Identifying the Need for Internal Financial Controls: Recognizing the importance of internal financial controls, Rahul decided to delve deeper into the issue. He observed that several financial processes were loosely managed, leading to confusion and potential errors in the company's accounts. Additionally, the lack of clearly defined roles and responsibilities made it difficult to trace errors and ensure accountability.
a. Protecting Financial Assets: Rahul realized that without proper controls in place, Techmantra' financial assets were vulnerable to misuse or misappropriation. By understanding internal controls, he could create a framework to protect the company's funds from unauthorized access and minimize the risk of financial loss.
b. Preventing Fraud: Upon investigating the financial discrepancies, Rahul also acknowledged that the absence of internal controls made Techmantra susceptible to fraud. Unscrupulous employees or outsiders could exploit the weaknesses in the financial processes to carry out fraudulent activities.
c. Ensuring Accurate Financial Reporting: Inaccurate financial reporting was another significant concern. Without proper controls, it was challenging to ensure the accuracy and reliability of the financial statements, leading to potential misinterpretations and uninformed decision-making.
d. Complying with Laws and Regulations: Techmantra, like any other company in India, needed to comply with various financial laws and regulations. Understanding internal controls helped Rahul develop policies that ensured Techmantra operated within the legal framework, reducing the risk of penalties and regulatory issues.
e. Improving Efficiency: Rahul noticed that inefficiencies in the financial processes were affecting the overall productivity of the company. By implementing internal controls, he could streamline financial workflows and improve resource allocation, leading to better efficiency.
f. Making Better Decisions: As the CEO, Rahul needed accurate and timely financial information to make informed decisions for Techmantra' growth and expansion. Internal financial controls would provide him with reliable data, enabling him to make strategic choices that align with the company's goals.
To address these challenges, Rahul decided to take the necessary steps to understand and implement internal financial controls tailored to Techmantra's needs. He consulted with financial experts, conducted internal audits, and involved his finance team to develop a comprehensive internal controls policy.
By understanding internal controls and proactively implementing them, Rahul successfully protected Techmantra's financial assets, reduced the risk of fraud, ensured accurate financial reporting, complied with applicable laws and regulations, improved operational efficiency, and made well-informed decisions that contributed to the company's long-term success in the Indian software development market.
Step 2. Identify the key areas where internal controls are needed
Not all businesses are the same, so the specific internal controls that are needed will vary from business to business. However, there are some general key areas where internal controls are essential for all businesses:
a. Bookkeeping, Accounting and financial reporting: It includes controls over –
o the keeping accounts records,
o the recording of transactions,
o the preparation of financial statements, and
o the safeguarding of assets.
b. Purchasing and procurement: it includes controls over –
o the ordering of goods and services,
o the receipt of goods and services, and
o the maintenance of vendor records.
c. Sales, credit and collections: It includes controls over –
o the billing of customers,
o the granting of credit,
o the collection of payments, and
o the management of bad debts
o the handling of customer disputes.
d. Cash management: It includes controls over –
o the receipt and disbursement of cash,
o the reconciliation of bank accounts, and
o the management of petty cash.
e. Human resources: It includes controls over –
o the hiring and onboarding of employees,
o the granting of access to sensitive information, and
o the handling of payroll.
f. Inventory management: It includes controls over –
o the ordering, receiving, storing, and issuing of inventory.
g. Information technology: It includes controls over –
o the access to and use of computer systems,
o the security of data, and
o the backup of data.
Step 3. Design and implement internal controls
Once you have identified the key areas where internal controls are needed, you need to design and implement controls that are appropriate for your business. While designing the implementing the controls, here are few consideration which should be taken into the account, such as:
a. Segregation of duties: This involves dividing the responsibilities for different tasks among different people, so that no one person has complete control over a particular process. For example, the person who records transactions should not be the same person who approves those transactions.
b. Approvals: This involves requiring that certain transactions be approved by authorized individuals before they can be processed. For example, all purchases over a certain amount should require the approval of the CEO.
Physical controls: This involves physically securing assets and sensitive information, such as by using locks, passwords, and security cameras. For example, the company's cash should be kept in a safe, and access to the company's computer systems should be restricted to authorized users.
Recordkeeping: This involves maintaining accurate and up-to-date records of transactions and other financial information. For example, the company should keep a record of all purchases, sales, and payments.
4. Monitor, test and update internal controls
Once Internal controls have been implemented should be dynamic and to be monitored on constantly at the reasonable interval to ensure that they are effective. This can be done by conducting internal audits or by hiring a third-party auditor with the approach mentioned below:
a. Establish a monitoring plan that outlines how the controls will be monitored on a reasonable interval with an exception. This plan should include –
o the frequency of monitoring,
o the methods that will be used, and
o the individuals who will be responsible for monitoring.
b. One way to monitor controls is to conduct regular audits. These audits can be conducted by internal auditors or by third-party auditors. The audits should assess –
o whether the controls are working effectively and
o whether they are still relevant to the risks that the business faces.
c. Data analytics can also be used to monitor controls. This involves –
o analysing data to identify patterns or trends that may indicate that a control is not working effectively.
d. If a monitoring or audit reveals that a control is not working effectively, the business needs to take steps to address the issue. This may involve –
o revising the control, providing training to employees, or
o implementing new controls.
e. Internal controls must be updated as and when needed, it may be to meet the changing requirement of the company, or change in the internal procedures and policies of the company. For example, if you start selling products online, you will need to implement new controls over the ordering and shipping of products.
Conclusion
Developing strong internal controls is an important part of being a Virtual CFO. By following the steps outlined above, you can help to protect your business's assets, prevent fraud, and ensure that its financial statements are accurate.
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